Banking system of USA

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As the preceding discussion illustrates, monetary policy works through the market for reserves and involves the federal funds rate. A change in the reserves market will trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit in the economy, and levels of employment, output, and prices. For example, if the Federal Reserve reduces the supply of reserves, the resulting increase in the federal funds rate tends to spread quickly to other short-term market interest rates, such as those on Treasury bills and commercial paper. Because interest rates paid on many deposits in the money stock adjust only slowly, holding balances in money (that is, in a form counted in the money stock) becomes less attractive. As the public pursues higher yields available in the market (for example, on Treasury bills), the money stock declines. Moreover, as bank reserves and deposits shrink, the amount of money available for lending may also decline. Higher costs of borrowing and possible restraints on credit supply will damp growth of both bank credit and broader credit measures. A change in short-term interest rates will also translate into changes in long-term rates on such financial instruments as home mortgages, corporate bonds, and Treasury bonds, especially if the change in short-term rates is expected to persist. Thus, a rise in short-term rates that is expected to continue will lead to a rise (though typically a smaller one) in long-term rates. Higher long-term interest rates will reduce the demand for items that are most sensitive to interest cost, such as residential housing, business investment, and durable consumer goods (for example, automobiles and large household appliances). Higher mortgage interest rates depress the demand for housing. Higher corporate bond rates increase the cost of borrowing for businesses and, thus, restrain the demand for additions to plants and equipment; and tighter supplies of bank credit may constrain the demand for investment goods by those firms particularly dependent on bank loans. Furthermore, higher rates on loans for motor vehicles reduce consumers’ demand for cars and light trucks. Beyond these effects, consumption demand is lowered by a reduction in the value of household assets — such as stocks, bonds, and land — that tends to result from higher long-term interest rates. The implications of changes in interest rates extend beyond domestic money and credit markets. Continuing with the example, when interest rates in the United States move higher in relation to those abroad, holding assets denominated in U.S. dollars becomes more appealing, and the demand for dollars in foreign exchange markets increases. A result is upward pressure on the exchange value of the dollar. With flexible exchange rates (rates that fluctuate as the supply of and demand for national currencies vary), the dollar strengthens, the cost of imported goods to Americans declines, and the price of U.S.-produced goods to people abroad rises. As a consequence, demands for U.S. goods are reduced as Americans are induced to substitute goods from abroad for those produced in the United States and people abroad are induced to buy fewer American goods. Such changes in the demand for goods and services get translated into changes in total production and prices. Lessened demand resulting from higher interest rates and the stronger dollar tends to reduce production and thereby relieve pressures on resources.